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Trading Points

Seller Beware: Money-Losing Bond Deals Lead to Suits
Against Underwriters

By

Jacqueline Doherty

Updated March 1, 1999 12:01 a.m. ET

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W atch out, underwriters: Bond investors are on the warpath. A number of deals sold in early 1998 turned into turkeys in less than a year, and the lawsuits have begun.

Recently, we reported that IDS is suing NatWest Capital Markets and McDonald & Co. over their underwriting of bonds for a Thai steel minimill. The bonds were sold last March and now fetch around 19 cents on the dollar.

Now Windigo Partners, an institutional money manager, has sued ING Barings for fraud and negligent misrepresentation in their role as lead underwriter of a debt offering from an Argentine cable company, Supercanal Holding.

The bonds were sold last May at a price of 100 and have plummeted to around 43. True, bonds of most Latin American issuers are trading at depressed prices owing to the spillover effect from Brazil's problems. But the bonds of another Argentine cable company, Multicanal, trade around 85.

ING received more than just underwriting fees from selling the bonds, the suit states. Supercanal used the proceeds from the bond deal to repay a $200 million bridge loan and $246 million of debt due to a group of lenders led by ING. The bond investors allege that ING made "selective disclosure concerning financial covenants," omitting those that indicated the company's liquidity was in jeopardy.

When the bonds were offered in May, Supercanal had about $100 million available on its bank line of credit. But on June 30, less than two months after the bond deal was sold, the company violated a bank loan covenant and lost access to its bank credit. The covenant restricted the amount of debt the company could have per cable subscriber.

The company, moreover, doesn't generate enough cash flow to make interest payments and meet working capital needs. Supercanal could make its first $17.25 million interest payment in November only by borrowing $2 million from Multicanal, according to the bondholders. And now the bonds are trading as if the company won't be able to meet its second interest payment in May.

"Nobody buys a bond if they don't believe it can make its first coupon payment," says Lynn Young, managing partner of Windigo.

Full Disclosure?

The folks at Windigo allege that ING officials failed to disclose that the debt-to-subscriber covenant was on the verge of being violated. The bond prospectus listed the existence of the covenant, but didn't spell out the ratios and terms involved in it. The only specific terms given were for a debt-to-cash-flow bank-loan covenant that the company hasn't violated.

"It would lead a rational person to believe they were discussing the covenant most in danger of being tripped," Young said. Indeed, at a roadshow, ING implied that the company's debt-to-subscriber levels were conservative compared to other emerging-market cable companies.

And ING's debt analysts had a longterm "buy" recommendation on the bonds as recently as September. The report was based on the company's March quarter numbers, which were late and not reported until September. The report states: "Liquidity is not a problem."

ING declined to comment on the case. However, in their response filed with the U.S. District Court in the Southern District of New York, the firm maintains that Windigo is a highly sophisticated institutional investor, and that it was clear the Supercanal notes were a highly speculative investment. Supercanal had lost money since its inception and had broken certain other covenants in its credit agreements. In addition, auditors had raised doubts as to its ability to continue as a going concern.

The response also states that ING "had no duty to disclose their best guesses concerning future covenant compliance." The law requires only disclosure of material facts, not economic forecasts. And finally, they claim investors cannot rely on statements from firm officials during a roadshow. Investment decisions should be based only on data in the prospectus.

Such controversies recall the wave of bondholder lawsuits in the early 1990s, after overleveraged companies filed for bankruptcy or reorganized after the economy turned down. But those suits were tough to win because underwriters and companies couldn't be held responsible for changes in the economic environment.

This time around, the lawsuits surround issues of lack of disclosure and faulty due diligence. The deals didn't go sour in a matter of years; it took just a matter of months. The outcome should be interesting to watch.

R ising interest rates have dented corporate-bond returns, though not quite as badly as they've hurt their Treasury bond counterparts. The Merrill Lynch corporate bond Index is down 1.94% from the start of the year through Wednesday, while the Merrill Treasury index has fallen 2.2%.

Professionals like to measure bonds on a relative basis, so they look at the spreads between yields on debt of companies and that on paper issued by Uncle Sam. Spreads on single-A industrial bonds have narrowed by about 0.15-percentage point this year, while those on double-B (the high end of junk) industrial bonds have tightened by a surprising 0.40-point, according to William Cunningham, a senior corporate bond analyst at Merrill.

In last week's bond selloff, spreads widened slightly in sympathy with the softness in the stock market and on fears that higher interest rates will slow the economy, says Cunningham. But he still believes "spread products" like corporates will outperform Treasuries over the next three months or so.

Indeed, investors continue to exhibit a voracious appetite for new issues. For example,
Corning
accelerated to last Friday an offering of $300 million of debt originally slated for this week owing to an overwhelming demand from investors, according to Kevin Kelly, a managing director at Goldman Sachs, the deal's lead underwriter. In addition, the bonds were priced with a lower yield than expected.

This week the supply will keep on coming. Most notably,
Pepsi Bottling Group
plans to sell $1 billion of 30-year investment-grade notes (in addition to its initial public equity offering, which is detailed in Offerings in the Offing ) and Charter Communications Holdings will begin marketing a junk-bond offering that may hit $3 billion.

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